Academic journal article The International Journal of Business and Finance Research

Indiosyncratic Risk and Earnings Noncommonality

Academic journal article The International Journal of Business and Finance Research

Indiosyncratic Risk and Earnings Noncommonality

Article excerpt

ABSTRACT

The seminal Campbell et al. (2001) paper showing that idiosyncratic risk has increased considerably in recent years has spawned a large number of articles to explain the phenomenon. In this paper, we propose growing earnings noncommonality as a possible source of the increasing idiosyncratic volatility. The empirical results of this research validate this proposition. Our conclusions stand the test of several robustness checks which show that market power and innovativeness previously considered in literature as sources of increased idiosyncratic volatility are not significant in the presence of earnings noncommonality. The findings of this research will be useful for analysts and investors involved in asset pricing.

JEL: G32, G35

KEYWORDS: Idiosyncratic Risk, Earnings Noncommonality

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

For over a decade now, financial researchers have been pursuing an asset pricing puzzle. The puzzle has its origin in a seminal paper by Campbell et al. (2001) in which the authors analyze the contributing factors of stock return volatility by its three sources - market, industry and firm, and report that the firm-specific or idiosyncratic component of the risk has increased dramatically in the sample period 1963 to 1997. In and of itself, this finding would not have generated much excitement because portfolio theory, and its extension the CAPM, assume that investors hold the market portfolio or are well diversified, and therefore idiosyncratic risk is not priced. However, Levy (1978), Merton (1987), and Malkiel and Xu (2002) show theoretically that idiosyncratic risk is priced if investors are not well diversified. Goetzman and Kumar (2004) find that only ten percent of the investors hold more than ten stocks in their portfolio, while according to Campbell et al. about 50 randomly picked stocks are required for a well-diversified portfolio. Brockman et al. (2009) verify the existence of a positive risk premium for idiosyncratic volatility internationally for 44 markets, and state that the average investor in these markets is not well diversified. Recent findings of Goyal and Santa Clara (2003) and Ang et al. (2006) also suggest that idiosyncratic risk is a priced risk factor. Because investors require compensation for bearing idiosyncratic risk, the apparent rise in idiosyncratic volatility reported by Campbell et al. has "become one of the most actively researched asset pricing puzzles," (Brandt et al. (2010)).

In this paper, we study the relation between idiosyncratic risk and earnings noncommonality. Specifically, we argue that earnings noncommonality is an important determinant of idiosyncratic return volatility. Earnings noncommonality is defined as the extent to which a firm's earnings performance is determined by firm-specific factors versus market and industry factors (Brown and Kimbrough (2011)). If firm level earnings are more (less) dependent on firm specific factors, then this is likely to result in higher (lower) levels of earnings noncommonality . The accounting literature indicates a firm's internal resources and its unique capabilities as factors that influence the noncommonality of earnings between firms (Piotroski and Roulstone (2004) and Elgers et al. (2004)). Palepu et al. (2007) consider intangible investments that form the core of the firm's competitive differentiation strategy as a major factor in creating earnings noncommonality. These intangible investments consist of moneys spent to create brand image, provide superior customer service, develop and improve products through R&D, and control systems that result in innovation and creativity. Despite these assertions, empirical evidence regarding the determinants of earnings noncommonality between firms is sparse.

Our basic premise is that earnings noncommonality has increased over time as firms try to improve their market position through differentiation in the marketplace. …

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